How Asset Allocation Works
Different correlation coefficients between investments are why asset allocation works much better for individual investors than anything else investors have created.
When investments move up and down perfectly in sync with each other over a certain time frame, its correlation coefficient is 1. When assets move in the opposite direction with each other, its correlation coefficient is -1. Both of these scenarios never happen. The average is around 0.7. All it takes is for a new asset not to be over 0.9 to add diversification value to a portfolio. This is the core of MPT (Modern Portfolio Theory), which started in the 1950s.
This 21st century's investment environment is a good example. Until Q4 2006, if you were stock picking or market timing in the US equity markets, you were getting poorer in flat-to-down equity markets. If you invested in asset classes that move in semi-opposite directions to the US equity markets (e.g., real estate, gold, or oil), then you've been getting richer.
The point is to hold a balanced mix of asset classes that have both good returns on their own, and go up and down at different times relative to the other assets in the portfolio. Determining which assets classes to hold is an art, a science, and depends on the circumstances and goals of the investor.
The different asset classes can be looked at as ingredients that go into making a pie. Each one individually tastes pretty bad. But when they’re all put together in the right combinations, the result is a delicious pie.
Holding an investment portfolio comprised of asset classes with healthy correlations to each other is just about the only way to reduce risk while still getting the returns that will end up beating the markets.
This is because whenever you check the portfolio's value, there's usually always something that's doing so well, that it keeps the portfolio as a whole from having negative returns, even when the US stock markets are down.